What’s The Rub With RAS?

by REIT Wrecks on April 24, 2008

Things are looking up… The Wall Street Journal reported Wednesday that investors and issuers of commercial mortgage-backed securities have something to cheer about for a change: The CMBX, a two-year-old credit-market index that has been heavily influencing CMBS prices, has been on a tear since late March.

As REITwrecks wrote earlier, the index had been under the influence of short sellers and trading at levels that would imply default rates of as much as 100% of the underlying commercial mortgages. As the WSJ reiterated, this is an all-but-impossible scenario, and with the index now oversold, investors are starting to pay more attention to the fundamentals of the commercial-property market.

REITwrecks has been emphatic about this disparity between price and value: for a long time, a myopic Mr. Market simply got it very, very wrong. Superficial similarities between residential and commercial real estate just did not and do not exist, and he has discounted the instrinsic values of the cash flows associated with commercial real estate far too heavily as a consequence.

Goldman Sachs’ CFO David Viniar underlined the point in a conference call with investors last month. “Many assets are being priced by the market at levels which are significantly below the levels that would stem from a fundamental valuation approach,” he said, while blaming depressed prices on “technical contagion” that eventually will abate.

As if on cue, over the past several weeks, spreads between Treasury’s and the AAA CMBX have tightened dramatically, which in turn has driven up the prices on actual bonds. According to the Wall Street Journal, the spread on the triple-A series 4 index, which tracks certain 2007 CMBS deals, has shrunk to less than a hundred basis points after almost reaching a 3-handle in mid-March.

“I see the rally as something that should have been expected given how far out of whack CMBX spreads had gotten versus stable commercial real-estate fundamentals,” said Darrell Wheeler, global head of securitized strategy at Citigroup Inc.

In another rare sign of stability returning to the market, last week Lehman Brothers and UBS lowered some yields on $1 billion of commercial mortgage-backed securities in what may mark the first CMBS of 2008 to price at yields lower than those first pitched.

According to Reuters, Lehman and UBS lowered yields on the “AAA” rated portions by 15 basis points to 25 basis points without losing orders. Previous issues had been sweetened with additional yield to draw investors shaken by the credit crunch and concerned that commercial real estate would falter in a U.S. recession.

Signs that sentiment has begun to improve have also been seen in the secondary market for CMBS. Spreads on outstanding 10-year “AAA” bonds have dropped by 100 basis points in the past month, according to JPMorgan Chase & Co.

After spending a considerable amount of time at the bottom of the lake, even the CLO/CDO market is starting to slowly heave its chest again. Traders report an increased appetite for European CLOs in the secondary market, but that the interest remains hampered by the lack of supply – caused primarily by sellers who see value in the paper and are thus unwilling to sell at such wide spreads. Previously there had been a steady trickle of assets from credit funds, SIVs and other forced sellers, which satisfied interested buyers, but this now appears to have ended.

The groundwork is being laid for a recovery in the second half of the year, suggest structured credit analysts at JPMorgan, who contend that higher relative value now compensates for the risk of mis-timing the bottom. CLOs could actually be part of the solution, given that banks are using the vehicles to move loans off their balance sheets.

However, demand is nothing what it used to be, with two thirds of the market for CLOs, CDOs and MBS having been wiped out, and those investors that do remain have become even more sensitive to underwriting and the managers behind each deal. Track record is everything. Demand has thus not even come close to recovering from pre-crisis levels, if it ever will at all.

And this is the main Rub with RAS: even with cash flowing assets match funded with long-term, non-recourse liabilities, RAS has been cut off from the oxygen it needs to grow FFO. Thus, in one of the best markets in 20 years, RAS has very little room to maneuver for new, choice assets at these premium spreads.

Combine this with lingering doubts about the Trust Preferred portfolio, much of which is covenant-lite and exposed to less solid credits and, indirectly, even shakier markets (think Accredited Home Lenders), and you still have a lot of uncertainty. Consequently, even with Thursday’s 7% jump, RAS is still trading near its credit-crisis nadir.

REITwrecks is conducting research on the Indian Ocean and will be relatively unplugged when RAS reports on May 5th, but mark-to-market is now old news. The issues to pay attention to now are the ability to fund growth (true for all REITs), and the health of the TruPs portfolio (RAS in particular).

As Lehman Brother’s CFO said, “we look at the mark-to-market adjustments as more temporary in nature,” the steep decline of mortgages and loans has been “driven by many technical factors, which may not reflect intrinsic value,” she said.

Unfortunately, the true intrinsic value of RAS’s TruPs portfolio is yet to be determined, and future value creation in this bountiful market hinges heavily on the Cohen’s funding creativity. Watch for both on May 5th.

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Disclosure: Long RAS at the time of publication

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